As asset class correlations rise, attraction to ILS & cat bonds increases

Managers of large multi-asset class investment funds are showing signs of concern that correlation levels between asset classes may break down, with their portfolio adjustments suggesting a shift towards assets that can protect investments.

Financial market have been difficult to predict in recent years and the correlation between asset classes a particular trouble for managers of large, diversified investment portfolios. As Investment Week reports here, correlation levels between global equity markets have risen in the wake of the global financial crisis. Now, with the threat of economic shocks continuing, correlation levels between equities and bonds are also following suit.

Typically these asset managers would maintain allocations across stocks and bonds, in various asset classes and geographies, at levels which would benefit their portfolio diversity. This approach would typically be expected to provide some portfolio protection as well, due to correlation factors which were generally accepted, but recent experience suggests that correlation cannot be taken for granted anymore.

According to Investment Week’s (IW) article these multi-asset investment fund managers are shifting assets into shock absorbers that they feel can protect their portfolios if asset class correlations diverge or break down. This means a shift into sector-specific investments and also cash, as managers seek safe havens.

As a demonstration of the way correlation levels have changed in traditional asset classes, IW cites the example of the IA UK All Companies and IA UK Gilt sectors, where the correlation level had been slightly negative historically, but in recent weeks has risen to 0.97 (which is extremely close to 1, judged to be perfect correlation).

Part of the issue here is a divergence of economic strategies at central banks, exacerbated by quantitative easing strategies, uncertainty surrounding the Euro due to Greece, continued low interest rates and plunging oil prices, which all contribute to general uncertainty and asset classes moving in unexpected ways.

The asset correlations that managers have been used to over the last ten years no longer ring true and if the current economic and investment climate persists, which most observers expect, this could only get worse and become ore unpredictable for investment managers.

Some multi-asset managers are seeking alternatives, the article says, citing property, infrastructure and other assets as examples of asset classes thought to be less correlated with wider economic factors. When correlation is rising across so much of the traditional investable space, the result is an increasing attraction towards anything that offers a degree of decorrelation.

Here’s where insurance-linked securities (ILS), catastrophe bonds and reinsurance linked investments come in and begin to look even more attractive in the currently challenging investment climate.

One asset manager, Adrian Lowcock, the head of investing at AXA Wealth, said that the risk levels of asset classes are currently disguised, making allocation much more difficult. 2008 saw a similar problem, when most asset classes went in the same direction, he explained.

Lowcock is quoted as asking; “At the moment the risk are disguised, but how do you find assets that are genuinely uncorrelated and protect investors from everything falling at the same time?”

How indeed should these asset managers avoid correlation risks in a market where the old, accepted rules on correlation appear to be breaking down?

Insurance and reinsurance linked investments, such as catastrophe bonds, sidecars, colateralized reinsurance and other ways of directly tapping the returns of catastrophe and insurance risks, are generally considered to be largely uncorrelated with financial markets and wider economic factors.

Of course, and as Artemis regularly writes, nothing can be considered totally uncorrelated, even ILS and investments in reinsurance risks. If the largest natural catastrophes occurred you would find financial markets moving south at the same time as the insurance industry suffered major losses, for example.

However the correlation levels are very low between ILS, catastrophe bonds, other reinsurance linked investments and more traditional asset classes, that is indisputable. ILS and catastrophe bonds also display very low volatility, when compared to other more traditional investment benchmarks, which should also be very attractive to investors right now.

So with correlation fear emerging among traditional asset managers ILS and cat bonds should be increasingly attractive to them, as an asset class with low correlation, low volatility and a wide range of possible returns depending on the strategy chosen (as wide as 4% to 20% per annum).

Patrick Connolly, a financial planner with investment manager Chase de Vere, is quoted in the IW article as saying; “We are very much aware of the risks of everything falling together. The only way to avoid correlation risk altogether is to move to cash or into one of the few absolute return funds that are not correlated to the market.”

The ILS market knows another way, allocate to insurance or reinsurance linked investments or catastrophe bonds. The only question is whether the ILS and reinsurance market could support the allocation volume needs of multi-asset managers seeking to escape from correlation?

Also read:

– Swisscanto favouring ILS investments over government bonds.

– Cat bond market averages 8.33% annual growth since 2002: Swiss Re.

– Swiss pensions look to ILS as alternative asset, but regulation hinders.

– On the non-correlation, or otherwise, of catastrophe bonds. And drooling.

– Correlation between insurance-linked securities returns and S&P500 returns declines.

– 2012 demonstrates catastrophe bonds lack of correlation to wider capital markets.

– Understanding the true nature of insurance-linked securities correlation.